Wednesday, June 19, 2013

Last month there were quite a few analysts predicting the Fed would start tapering off QE purchases in June. My response was Three words: Will Not Happen.

Now we are seeing a flurry of articles with headlines suggesting reducing the monthly purchases of assets is "close" or "near". It depends on the definition of "close" or "near", but it is clear tapering will not happen until later this year at the earliest. Here is the key quote from Bernanke:

"If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year. And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7%, with solid economic growth supporting further job gains, a substantial improvement from the 8.1% unemployment rate that prevailed when the committee announced this program."

• First, year-over-year GDP growth would have to be in the 2.3% to 2.6% range in Q4 2013. The first half of 2013 will probably be just over 2% - so this suggests 2nd half GDP growth in the 2.5% to 3.2% range. If the FOMC decides to taper in September, growth would have to seem fairly strong in Q3. By December, the FOMC will have Q3 data and a sense of growth in Q4 - and the impact of fiscal policy (the key downside risk to the U.S. economy is excessive fiscal tightening). So even if the economic data is consistent with the FOMC forecasts, it seems tapering in December is more likely than September. NOTE: Economic growth for 2013 was revised down slightly in the projections released today - several articles have incorrectly stated that growth was revised up.

• Second, the unemployment rate will have to be on track to be in the 7.2% to 7.3% range in December. Since December 2012, the unemployment rate has fallen from 7.8% to 7.6%, but much of that improvement was due to a decline in the participation rate from 63.6% to 63.4%. If the participation rate stays flat for the remainder of 2013 (about what I currently expect), then job growth would have to increase to reach the Fed's projections.

• Third, inflation would have to be increasing. Over the first four months of 2013, the PCE price index increased at a 0.3% annualized rate (core PCE increased at a 1.0% annualized rate). This is significantly below the Fed's target. The FOMC members believe this low inflation is partially due to transitory factors, but I expect the Fed will want to see some increase in inflation before reducing the pace of asset purchases.

Although I think the future is bright - and the Fed's projections are possible, I don't think the Fed will have enough positive economic data to "moderate the monthly pace of purchases" by September. Right now it seems likely they will start tapering in December or in early 2014. So little has changed on timing - even with the somewhat more positive tone of the FOMC statement, especially that "downside risks have diminished".

Tapering is coming, but can December be described as "near" or "close"? If so, I haven't even started my Christmas shopping yet ...

Of course, Bernanke did not say September. But I think he made clear that assuming the Fed's forecasts hold, they see that asset purchases will be gradually reduced beginning later this year with the expectation that the Fed will QE draw to a close by the middle of next year. He confirmed my suspicion that although the Fed sees the fiscal sector as a drag on overall growth, they do not believe it has harmed the underlying momentum of the economy. I would even say that he sounded relatively optimistic. Thus, downside risks have diminished and it is appropriate to begin reducing accommodation.

Interesting, he seemed to set a trigger, not a threshold, for ending QE - the program should be concluded when unemployment hits 7%. I am surprised that he set a number, although it is consistent with the idea that the Fed wants to end QE well ahead of the 6.5% threshold for unemployment. Watching the unemployment rate just became even more important, as a faster than expected move to 7% will be associated with a faster end to QE.

In Memoriam: Doris "Tanta" Dungey

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